From the Great Moderation to the global crisis: Exchange-market pressure in the 2000s

Joshua Aizenman, Jaewoo Lee, Vladyslav Sushko22 October 2010

Exchange-rate policy is emerging as one of the most controversial issues from the global crisis. This column looks at how emerging markets have responded to exchange-rate pressures over the last decade. Among its findings is that emerging markets’ hoarding of international reserves is far better explained by financial factors than by trade concerns, both before and during the crisis.

Before 2008 and the onset of the global crisis there was a period of remarkable drops in macro volatility and the cost of risk in advanced countries, a period dubbed the “Great Moderation” (Stock and Watson 2002).

During the first phase of the Great Moderation (the 1990s), emerging markets moved towards deeper financial integration and greater exchange-rate flexibility.

The growing financial integration, however, exposed emerging markets to a series of virulent financial crises. The resulting turbulence forced emerging markets to deal with fundamental deficiencies: consolidating their fiscal positions, reducing their overall balance sheet exposure, and buffering their positions with an unprecedented accumulation of reserves. The remarkable decline in the risk premia for emerging markets during the 1990s was thus achieved in the old fashioned way, by improving their balance sheet, solidifying their tax base, and rationalising their public expenditure.

During the second phase of the Great Moderation (the 2000s), most emerging markets found themselves sharing the benefits of low macro volatility with advanced countries, including a further remarkable drop in country risk premia, and large inflows of capital from advanced countries which were chasing after higher yields.

The Great Moderation period came to an abrupt end with the global crisis of 2008 that originated in the US (Cecchetti 2007).

The unfolding of this crisis provided a unique challenge for emerging markets. Unlike the typical emerging-market crises of the 1990s, they had to cope with a global crisis which involved few domestic causes. Most emerging markets entered the global crisis with a sizable buffer of international reserves, and managed exchange-rate flexibility. Furthermore, there had been a gradual shift in the mix of positions, reducing the weight of debt liability, and increasing the weight of equity liabilities in emerging markets (see Figure 1). Arguably, this configuration should have allowed emerging markets a broader choice of adjustment than the ones facing them during the financial crises of the 1990s.

In a recent paper (Aizenman et al. 2010), we study the external pressures facing emerging markets and contrast their adjustments during the 2000-2006 Great Moderation phase with the adjustment observed during the 2008-9 crisis. Unlike the advanced countries, most emerging markets were not able to rely on borrowed reserves via swap lines, and were therefore more exposed to the need to adjust abruptly to the global crisis.

Using quarterly panel data during the Great Moderation and the crisis period of 28 emerging markets, we study the role of reserves in the development of exchange-market pressure for emerging markets. Following Girton and Roper (1977), we measure exchange-market pressure as a weighted sum of exchange-rate depreciation and international reserves loss. Exchange-market pressure is the result of forces coming from the financial sector through various capital flows and from international trade of goods and services (see Rose and Spiegel 2009 and Frankel and Saravelos 2010). A positive exchange-market pressure indicates a net excess demand for foreign currency, alleviated by a combination of reserve loss and depreciation – with the opposite for negative exchange-market pressure.

One of our aims is to compare the role of financial and trade factors before and during the crisis. We capture trade factors by changes in the balance of trade and in the commodity terms of trade, and financial factors by changes in short-term and portfolio debt, equity and foreign direct investment (FDI) inflows. During the Great Moderation period, higher exchange-market pressure is associated with lower income growth, higher inflation, deteriorating trade account and commodities’ terms of trade, higher domestic credit growth, net outflows of portfolio investment debt, and a fall in the gross short-term external debt.

During the crisis period, the correlation between the exchange-market pressure and income, and the correlation between the exchange-market pressure and measures associated with deleveraging (reduction in gross short-term external debt and net portfolio debt inflows) remained significant. Moreover, the coefficient of gross short-term external debt quintupled at the onset of the crisis and then gradually declined. The coefficients suggest that cross-border deleveraging was the main force behind emerging markets’ rise in exchange-market pressure during the global financial crisis, with emerging markets’ stock markets themselves only playing a secondary role. In addition to cross-border deleveraging, emerging markets were greatly affected by the fall in commodity prices during the initial phase of crisis.

We find evidence that financial factors played a much greater role in accounting for emerging markets’ hoarding of international reserves both before and during the global crisis. While the correlation between international reserves and financial factors (especially short-term debt) rose sharply during the crisis, the correlation between international reserves and trade factors were similar before and during the crisis. During the Great Moderation period, we find that the effect of a one standard deviation increase in the combined “hot money” variables on international reserves is more than twice as large as the effect of a one standard deviation increase in trade balance (3.7% versus 1.6%). This suggests the prominence of financial factors in accounting for the reserve hoarding by emerging markets during the Great Moderation, possibly associated with precautionary motives (Aizenman and Lee 2007). The same comparison based on one standard deviation variations suggests that the relative impact of “hot money” flows almost doubled during the height of the global financial crisis throughout 2008 compared to the Great Moderation period.

We also find that the association between cross-border financial deleveraging and exchange-market pressure is highly significant economically, especially during the crisis period. During the Great Moderation, 2000-2007 a 10 percentage points decline in gross short-term external debt to GDP ratio is associated with an approximately 1.8 percentage points higher exchange-market pressure. During the onset of the crisis in early 2008, the impact of the same 10 percentage points deleveraging is a 10 percentage points higher exchange-market pressure. (These results are consistent with the view that during “flight to quality” in less liquid markets, elasticities get smaller in absolute terms forcing a greater exchange-rate adjustment.)

Figure 2 shows the negative correlation between exchange-market pressure and the change in gross short-term external debt (as a percent of GDP). As the financial crisis unravels throughout 2008, the mass of emerging markets shifts towards the top left quadrant, indicating deleveraging combined with positive exchange-market pressure. The mass then shifts back after Q1 2009, indicating a reduction in deleveraging pressure and in exchange-market pressure. Despite the significant reduction in exchange-market pressure by Q2 2009, a large fraction of emerging markets continued to experience deleveraging pressure, as indicated by their migration to the bottom left quadrant.

Notes: The Figure depicts the shift in the mass of emerging markets to the upper left quadrant of positive exchange-market pressure combined with short-term debt deleveraging (captured in panel regressions) during 2008:Q4 and 2009:Q1.

Note: The association between deleveraging in short-term external debt and exchange-market pressure, sampled during the height of the crisis and one year prior; robust to seasonal effects.

Figure 3 traces the association between deleveraging in portfolio debt inflows and emerging markets’ exchange-market pressure. We observe the shift in the mass of emerging markets to the upper left quadrant of deleveraging combined with positive exchange-market pressure during Q4 2008, followed by a gradual shift back in early 2009.

Notes: The Figure depicts the shift in the mass of emerging markets to the upper left quadrant of positive exchange-market pressure combined with portfolio debt deleveraging (captured in panel regressions).

Note: The association between deleveraging in portfolio debt and exchange-market pressure, sampled during the height of the crisis and one year prior; robust to seasonal effects.

Contrary to cross-border deleveraging, which was closely correlated with the rising exchange-market pressure of emerging markets during the crisis, emerging markets’ stock markets played only a secondary role. Negative stock market returns are significantly associated with exchange-market pressure only when Q1 2009 and Q2 2009 are included in the crisis window, and not before. In addition, emerging markets were greatly affected by the fall in commodity prices during the initial phase of the crisis, although the relative impact of trade factors remained virtually the same in magnitude during the financial crisis and the Great Moderation period that preceded it.

We also study the association between several country-level indicators, as of 2007, and the exchange-market pressure measure during the height of the crisis in Q4 2008 in a cross sectional regression. We found that that richer emerging markets experienced greater exchange-market pressure during the crisis. Greater FDI inflows prior to the crisis were associated with a lower crisis exchange-market pressure, while greater portfolio debt inflows with a higher crisis exchange-market pressure, and this effect is much larger than the mitigation effect associated with greater FDI inflows.

We conclude with an analysis of the factors that account for the trade and financial exposure of emerging markets during the crisis, finding that pre-crisis financial and trade openness are significant predictors of the financial and trade shock during the crisis. The severity of the financial shock was further exacerbated by financial ties to the US, while the trade shock was more severe in emerging markets with a larger commodity export share.

The prominence of financial relative to trade factors during the crisis of 2008-9 might not be a surprise. After all, the trigger of the crisis was the meltdown of the US financial system. Yet, the prominence of financial relative to trade factors during the Great Moderation period preceding the crisis implies that even in tranquil time, financial flows and the build up of financial exposure dominated the evolution of foreign currency markets, and the sizable hoarding of international reserves by emerging markets.

The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.